Closing on Our First Rental Property

Posted by Madison on April 27, 2009

We’re closing later this week on a 3 unit, 100 year old rental house. It’s in a prime location, close to the university and hospitals. It’s currently rented until summer of 2010. (In the area, leases are usually signed for the following school year in the spring.)

It’s our first real estate investment and our first venture into being landlords. Getting Started in Real Estate Investing has some of the resources and evaluation tools we used for this deal. Here’s how it all came together.

Negotiation and Financing

Offer. We got a heads up from our Realtor about the house two days before it was listed. We set up an appointment immediately. The house was listed for $285,000. We offered $260,000 for the property with the seller to replace the siding. Another offer came in the following day and they countered without the siding at the same price, so we took it.

Inspection. After the inspection, we found the major problems to be the furnaces, air conditioners, and water heaters were at the end of their life expectancy. We asked the sellers to replace the furnaces and air conditioners, which they agreed to. It will cost them about $9,000.

Loan. We secured a 5.875% 3/1 commercial ARM with a .25 point. We needed a commercial loan because we’re buying it with our partner under an LLC. With 20% down and some money in reserves for maintenance, we’re throwing in $32,000.

Insurance. We’re getting our landlord liability policy through Allstate. They had a cheap rate with good coverage. We’re also considering moving our personal insurance policies there, because their umbrella covers the landlord policy, which is not common at other insurance companies.

Management and Maintenance

Contractors. Angie’s List has ratings of local contractors. The popular categories are: plumbing, electricians, remodeling, roofing, carpeting, landscaping, and painting. They’ll be helpful when it comes to getting some of the work done in the inspection that we’ll be responsible for.

Management. Our partner will be handling the property management. It’s part of the reason doing this partnership was appealing. Scott and I don’t have any interest in handling the phone calls and dealing with the tenants. In exchange for his services, he’ll get a cut of the rent.

Apartment Searches. I had a few people contact me asking if they could rent our new apartment. However, since it’s already filled, a good resource to search for apartments is at Apartments.com.

Cash Flow

Here’s how the numbers look on a monthly basis:

  • Rent: $2310
  • Mortgage payment: $1230
  • Taxes: $450
  • Insurance: $65
  • Utilities: $65
  • Management, maintenance, reserves, etc: $350-$450

Based on the amount of maintenance needed each month, it should cash flow between $50-$150 to start off with.

Leverage Strategy

As always, I like to use other people’s money when it makes sense. Last week, I got an offer for a 5.99% for the life of the balance transfer on a couple business credit cards.

Combine that with Penfed’s 2.99% balance transfer offer right now and we’re financing the whole thing. By using this money instead of our own savings for the down payment, it will triple our IRR! We’ll have a bit of negative cash flow on paper, but the tax savings for depreciation should cover it.

Next Steps

We’re busy planning our action steps for our next property. Now that we know a little more of what we are doing, we’re going to also include foreclosure listings and home auctions.

We’re actually going to an auction this weekend to see if we can’t score a deal, as one of the local builders is unloading more than 50 properties. If it’s exciting, I’ll post updates on Twitter while we are there!





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Comments to Closing on Our First Rental Property

  1. Congrats on closing on the deal! I know that you have leases already in place, but it’s typical to account for vacancy costs as an expense.

    Best of luck and I look forward to hearing updates on your real estate adventures.

    Million Dollar Journey

  2. Congratulations on closing! Your experience with taking on a rental property coincides with the timing of my own.

    In my case, I am converting my primary residence to a rental. I talk about this conversion on my website. We refinanced to avoid our ARM readjustment and to lower our mortgage and at the end of the day, we expect to bring home around the same in cash flow.

    But, you already have tenants. My next steps now are to find tenants before we move away in July. Good luck to you and I will stay tuned to hear your updates.

    Su Prieta

  3. Congratulations!
    I was wondering what financial institution you used for the commercial loan? I used Commercial Direct when I bought a multi-family 2 years ago and am looking to refinance in 3 more years. My rate was not so good considering my credit was great. It was my first commercial property and I learned a lot during the process though.

    Also, what factor affected your decision to go with a 3/1 ARM?

    Thanks!

    Sky

  4. Good luck with your first rental. I’ve done the rental thing before, and I found it to be just too much hassle. Even at $300 or $400 a month positive cash flow, and lots of tax write offs, I can still think of easier ways to make the same income.

    I had the opportunity to buy a multiple unit rental house recently, and I opted for a lake front cottage instead. It was half the price and zero hassle. I figured that I deserved a nice winter retreat much more than I deserved taking care of rental units and managing renters.

    Nevertheless, good fortune to you and your adventure as a landlord. I wish you the best.

    Clair

    Clair Schwan of Frugal Living Freedom

  5. These will not positive cashflow. Long-term it will be a net worth builder, but not provide cashflow. You need 20+ units before such an investment becomes a cashflow generator.

    For one, your reserves are set too low because management fees are typically 5 to 6%.

    You need to amortize amounts for your major systems over estimated their useful lives, such as HVAC, roof, floor coverings, siding. Each day those are essentially rotting away, and will eventually need replacement. If you haven’t adequately set aside in a reserve account for these, you have essentially subsidized your tenant’s stay.

    Chris Wathen

  6. Congrats… would make me nervous in an excited kind of way to close that kind of deal. Best of luck!

    No Debt Plan

  7. Congratulations! My husband and I own a beach rental and we have considered purchasing another. We only rent a few months of the year, so our day jobs have to cover the rest of the mortgage, but it is the best decision we’ve ever made with our money.

    One Frugal Girl

  8. Now the beach rental idea makes sense. The daily rents are something more like hotel rates, and you can make your investment back quickly. The only issue is getting someone reliable to do the daily, weekly cleaning and the percentage of rent demanded by the property manager. Some want 50%!

    Yeah right, I’m going to make the investment and share half of what can be made with someone that has no skin in the game. Not likely.

    Clair

    Clair Schwan of Frugal Living Freedom

  9. How/Why was it possible to put someone elses money as your down payment (credit card)? In other words you did 100% financed, ARM. I am sure the mortgage company doesnt know this or they would have ran.

    This seems like eaxclty what brought down the market?

    joe

  10. I’m also curious how you were able to get a loan using the credit card money for a down payment. Can you give us a ballpark figure on your net worth and liquid assets?

    I am trying to get into rental property and my net worth and liquid assets right now are too small for banks to lend to me based on Balance Transfers.

    This with my credit being 810 and having a stable job!

    Ted

  11. @ Sky: We’re using a local bank for the loan. 3 years loans are all the banks offer for commercial loans because of the bond market.

    @ Joe: Technically, we used our own money for the down payment. Then I turned around and did a balance transfer to repay myself. It’s just another form of credit card arbitrage.

    The mortgage company is well aware that I have over $100k on credit cards, but I’m sure they are fine with it since I have the money in the bank to pay it off if I ever need to.

    @ Ted: We’ll just say that we could have paid cash for the rental and leave it at that. The bank isn’t taking much risk on us since we didn’t need the financing, but we chose to do so because leverage allows more wealth accumulation.

    Madison

  12. Best of luck with your new investment. Did you consider the capitalization rate when you valued the property. Your cap rate seems somewhat low for this new economic enviroment.
    Thanks,
    Seb

    Seb

  13. @ Seb: We did, and it is low. The location (near the university) draws a much lower cap rate than other areas of town. However, as a trade off, we’ll see higher appreciation, and very low, if any vacancies.

    Once we get further from downtown, the cap rates go up, but so do the vacancies and the risk.

    Since it was our first property, we wanted to do a low risk, low reward investment. As we learn more, and get better at it, we’ll probably take a little more risk.

    Madison

  14. I agree with Seb. I would have figured a minimum of 10% vacancy & collection; 35% expense ratio; and a 9% cap rate. About $180k would be the target price in my mind.

    Chris Wathen

  15. @ Chris & Seb: You both seem very knowledgeable about real estate investing, and I’m looking forward to learning more from you.

    When you consider the 9% cap rate, do you take into account the area of the country you’re investing in?

    I ask because we’re in an area that has not seen depreciation or problems with real estate from the economic environment plaguing much of the nation right now. I reviewed the comps and none of them came close to 9% in the area this house is in.

    I’d love to hear both of your thoughts on our second property which I’ll post about later today. The numbers are better than this one, so I think we’re improving as we go, but I’m open to your thoughts for additional improvement. As you know, real estate investing is brand new to me!

    Madison

  16. Hi Madison,
    Seems like I’m a few days behind, but I have to agree with Chris and Seb. In 2002 I bought a 3 flat + garden in a trendy area in Chicago. Lots of students and young professionals providing what I thought was a solid rental base. I am also not new to this because I helped my dad own and manage a 15-flat that he owned for about 20 years.

    I would especially point to two elements 1) the vacancy factor, and 2) the maintenance expenses. It looks like your rents are about $770/month. Using your optimistic cash flow numbers of 50- 150/month (assume 100/month), then one month’s vacancy of any unit eats up about 8 months of your profitability for the year. You WILL have vacancies. You will also have plenty of expensive repairs in a 100-year-old building – my experience certainly goes in this direction. Your rental rates will also fluctuate considerably. I wish you all the best, but I don’t think that it is likely that you will have positive, sustainable cash flow any time soon. If I has to point to one more element, I would point to the utilities – if you number is anything other than just water and sewer, you better start a reserve today.

    One of the biggest things that I wish I understood better before I bought was that I was NOT, absolutely NOT, buying an “investment” – I was buying a business. That means that a lot of the “investment” ways of valuing things go right out the window. I got my initial value wrong by trying to value it as an investment, and it seems like you are doing what I was doing then. I still have the property that I bought, and after I pluncked a bunch more equity into it, it is now cash flowing, but I would probably be doing only a little less well if I was in bonds – and that’s without all the liability risk.

    I would also recommend taking real estate licensing classes in your area – not for the actual license, but to learn about how the business works.

    One thing is for certain, when I went to auctions last year, my numbers were solid as hell – like those of Chris and Sebs. (Actually, based on my experience, I don’t even view those numbers a conservative – they are more like minimal realistic numbers. More conservative would be a 15-20% vacancy number.)
    At the three auctions that I went to, they didn’t meet my price on any of my target units – and I am absolutely fine with that. I really wonder how many of those people that bought would now be willing to sell to me at my number. I think plenty.

    You are a very, very smart person and I really enjoy your blog. Your analysis on so many different things is very, very impressive. However, I would urge you not to buy more investment property until you have digested this one over the course of the next 2-3 years and you get a feel for the knocks. Best of luck.

    Joe Average

  17. Joe has a lot of good points, but his best was to digest this one for this one for the next 2-3 years before you buy any more units. Deals will always be available, so don’t get too anxious thinking you’ll miss the next one.

    Chris Wathen

  18. That’s pretty decent cashflow.
    I’ve been looking around here in Vancouver and the numbers don’t seem to add up.
    Congrats!

    TStrump

  19. Like Joe, I am also a few days late. Congrats on your purchase….Making $100/month per unit/door for rental property with a mortgage on them is acceptable to most landlords.

    Here’s how the numbers look on a monthly basis:

    Rent: $2310
    Mortgage payment: $1230
    Taxes: $450
    Insurance: $65
    Utilities: $65
    Management, maintenance, reserves, etc: $350-$450
    Based on the amount of maintenance needed each month, it should cash flow between $50-$150 to start off with.

    Paying $260K for a house that rents for $2310
    $2310 rent
    $1155 expenses (50% rule of thumb)
    $1155 NOI
    $1230 P&I payment ($260K,5.875%, 3/1 years)
    -$75 cash flow

    This formula is more reliable because it factors in more expenses than you have not accounted for.

    This information was found on biggerpockets dot com. Search “understanding 50% rule/ 2% rule”
    Disclosure: I am not affiliated with the above site, but I have learned a lot and saved alot of DOLLARS.

    Good Luck, D

    D

  20. This formula is more reliable because it factors in more expenses than you have not accounted for.

    Sorry, Should read- than you have accounted for.

    D

  21. @ Joe: Thank you very much for the helpful tips! It’s extremely useful to hear from someone who has been there… especially your similar property in Chicago. Obviously, I’m very new to the game, but I am willing to learn, so please continue to share your tips!

    I’ve taken your advice, and we’re going to slow down for the time being and work on being able to accurately predict expenses. I set up a spreadsheet to track the predicted versus actuals and calculate the return by year.

    @ D: Thanks for the formula! I’m headed over to read all about it. Ironically, I used that formula on the condo we bought at the auction, and it cash flows better than we estimated.

    I appreciate everyone’s help in learning about investing in real estate! It’s always fun to learn something new, but even more fun, when there are people to help you learn.

    Madison

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